According to the CAPM, a rational, risk averse investor would be least likely to choose as his optimal portfolio: A. a 100% allocation to the risk free asset. B. the global minimum variance portfolio C. a 130% allocation to the market portfolio. Why is the answer B correct?
CAPM assumes that there is a risk-free asset. Thus, every investor’s optimal portfolio will lie on the CML, which runs through the risk-free asset and the tangent (market) portfolio. The tangent portfolio cannot be the global minimum variance portfolio (unless the GMVP has a variance of zero, which cannot happen in practice): the line tangent to the efficient frontier at the GMVP is vertical; the CML is not vertical. The GMVP will always be below the CML.
Depending on the amount of risk aversion, the investor’s indifference curves could be tangent at any point along the CML; two such points are 100% risk-free asset and 130% tangent (market) portfolio.
I never saw this in schweser readings. Thank you once again.
I don’t know if I’ve seen it there or not. I just like to draw pictures.
Once again, it’s my distinct pleasure.
This seems a bit tricky I think I saw this and answered it incorrectly as well. Only because one would think that by them saying risk averse, one would question why it would be feasible for them to hold 130% of the market portfolio. It seems that would be action for an investor who has a flatter indifference curve and seeks more risk / return characteristics.
For those who don’t like to draw pictures like S2000, just note that with a Risk-Free asset, the CML always sits above the efficient frontier. So, other than the market (i.e. tangency) portfolio, any portfolio on the efficient frontier is dominated by a portfolio on the CML regardless of an invester’s level of risk aversion. In other words, if an investor picks a portfolio on the efficient frontier, there’s another portfolio on the CML that has equivalent risk and a greater expected return.
Not to put too fine a point on it, but more risk-averse investors have _ steeper _ indifference curves than less risk-averse investors, not flatter indifference curves.
thanks a lot for the info.
I hope that it helps.
yeah typo thanks for catching
We all make 'em.
(Thank goodness you don’t have to type the answers for the real exam!)